Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, 3rd Edition (10 page)

Watch for Companies That Select Inappropriately Low Discount Rates.
Xerox selected unrealistically low discount rates, which allowed it to record more of the lease payments as up-front revenue. For example, in the late 1990s, it assumed discount rates ranging from 6 to 8 percent on many Brazilian leases, even though the average local borrowing rates regularly exceeded 20 percent. The SEC contended that had Xerox used a discount rate more in line with the market, revenue on Brazilian leases would have been $757 million lower during the period 1997 to 2000.

Be Aware When Companies Alter the Terms of Existing Lease Arrangements.
Xerox also allegedly accelerated revenue by incorrectly accounting for price increases and lease extensions imposed on existing lease customers. Accounting rules state that companies should recognize the impact of these changes over the lease term. However, Xerox was impatient, and in 1997 through 1999 it pulled forward approximately $300 million of equipment revenue that should not have been recognized until much later.

Recording Revenue on Long-Term Arrangements with Multiple Deliverables

A third type of long-term arrangement that is subject to accelerated revenue recognition as a result of aggressive management estimates is one that has “multiple deliverables.” In this type of arrangement, the seller provides several distinct, but intermingled deliverables over an extended period of time. For example, wireless telecom companies often package mobile phone service and a cell phone handset together in the same contract. Sometimes the handset is sold to the customer at a greatly discounted price (or even given away for free), as long as the customer also agrees to a two-year service contract. Accounting rules require the seller to allocate a portion of the total contract value to the handset (to be recognized as revenue up front) and a portion to the service contract (to be recognized over the life of the contract). The seller uses assumptions in estimating how to split the revenue between the two deliverables.

By changing these assumptions or contract details, companies can influence the distribution of revenue in a way that may allocate more revenue to the “front end” of the contract (handset) and less to the “back end” (phone service). Investors should therefore keep an eye on the inputs (often discussed in company footnotes), including any structural changes to standard contracts. For example, Japanese telecom service provider Softbank changed the payment structure on its mobile phone contracts in 2006 in a way that increased the price of the handset and decreased the price of the monthly service, which may have allowed more revenue to be recognized up front. Monitoring receivable balances can help spot changes, as well. Softbank’s days’ sales outstanding increased from 51 days in the quarter it changed the payment structure to 61 days and 74 days in the two subsequent quarters.

Recording Revenue on Utility Contracts Using Mark-to-Market Accounting

Enron got creative with its accounting by conveniently forgetting that it was primarily a utility company, and instead pretending to be a financial institution. As a utility, Enron entered into long-term commodity delivery contracts with customers (e.g., selling future delivery of natural gas). Economic sense should have told investors that Enron, a utility company, must record revenue on these long-term service contracts only when the service, such as delivery of gas, had been provided. However, Enron curiously failed to treat these arrangements as service contracts. Instead, it defined them as the sale of financial trading securities or, more specifically, the sale of commodity futures contracts. Totally inappropriate, but quite clever!

Using this wacky interpretation as justification, Enron adopted an accounting methodology that was specifically intended for use by financial institutions that trade securities such as futures contracts: mark-to-market accounting. Under this method, the service contract would be viewed the same way as any other tradable security, which meant that all expected profits under this contract should be recorded immediately. As estimates of contract profitability changed over time (resulting from actual activity under the contract), the value of the “security” would be adjusted, as well.

Moreover, there were no actual markets for many of the contracts Enron was selling, which allowed Enron to use its own aggressive assumptions in determining the fair value of the contracts and any future markups or markdowns. This gave Enron’s management a tremendous amount of discretion in determining its quarterly earnings, effectively allowing the company to mark not to the market, but rather to its own desired results as dictated by its internal financial model (jokingly referred to as “mark to model” or “mark to make-believe”).

Warning of Premature Revenue Recognition:
Companies adopting an acceptable methodology (such as percentage-of-completion or mark to market) that was intended for other industries.

Mark-to-Market Accounting Became a Revenue-Enhancing Drug for Enron.
When a company selects a permissible accounting method (such as mark to market) that is intended for a different industry (such as financial institutions) or a different type of transaction, investors should view this act no differently from selecting an approach that is explicitly prohibited by GAAP. (Auditors, take note of this point!) By adopting an accounting methodology that completely belied the economics of its utility business, Enron rapidly accelerated revenue that should not have been earned for many years.

Now it should be clear to you how Enron’s revenues grew at an unprecedented rate—from $10 billion to $100 billion in four short years, while it took most of the others in the elite “$100 billion club” decades longer to reach that lofty peak. Mark-to-market accounting used inappropriately by Enron and undetected (or simply blindly unquestioned) by its auditor can be viewed for what it really was: a “revenue-enhancing drug” that seduced investors.

3. Recording Revenue Before the Buyer’s Final Acceptance of the Product

In the first two sections of this chapter, we focused on the seller’s performance of its obligations under the contract. In the next two sections, we shift our focus to the buyer. This section deals with three types of tricks that produce revenue before final acceptance by the buyer, specifically, recording revenue:

(1) 
before the shipment of product to the buyer

(2) 
after shipment, but to someone other than the buyer

(3) 
after shipment, but while the buyer still has the ability to void the sale

Seller Records Revenue Before Shipment

One problematic and often controversial method of revenue recognition involves so-called bill-and-hold arrangements. Under this approach, the seller bills the customer and recognizes revenue, but continues to hold the product. For most sales, with a few exceptions discussed in the prior section, revenue recognition requires shipment of product to the customer. Accounting guidelines allow revenue to be recognized in bill-and-hold transactions, however, provided that the customer requests this arrangement and is the main beneficiary. For example, if the buyer does not have adequate storage space, it may ask the seller to hold on to the purchased goods as a courtesy. Under no circumstances can early recognition of revenue occur under a bill-and-hold arrangement if the arrangement is initiated by the seller for the benefit of the seller (i.e., to record revenue at an earlier date).

Watch for Bill-and-Hold Transactions Initiated by the Seller
. If a seller initiates a bill-and-hold transaction, investors should assume that the seller is attempting to recognize revenue too early. For example, Sunbeam CEO Al Dunlap used a bill-and-hold strategy in order to make the company’s financial performance appear better than it really was by artificially inflating Sunbeam’s revenue.

Sunbeam, anxious to boost sales in its “turnaround year,” hoped to convince retailers to buy grills nearly six months before they were needed. In exchange for major discounts, retailers agreed to purchase merchandise that they would not physically receive until months later and would not pay for until six months after billing. In the meantime, the goods would be shipped out of the grill factory in Missouri to third-party warehouses leased by Sunbeam, where they would be held until the customers requested them.

Nonetheless, Sunbeam booked the sales and profits from all of the $35 million in bill-and-hold transactions. When outside auditors later reviewed the documents, they reversed a staggering $29 of the $35 million and shifted the sales to future quarters. In doing the audit, Arthur Andersen questioned the accounting treatment of some transactions. But in almost every case, it concluded that the amounts were “immaterial” to the overall audit. Sometimes detecting signs of aggressive accounting is close to impossible. In the case of Sunbeam, it required nothing more than reading the revenue recognition footnote in the company’s 10-K.

SUNBEAM’S 10-K FOOTNOTE DISCLOSURE TOLD THE STORY

The Company recognizes revenues from product sales principally at the time of shipment to customers. In limited circumstances, at the customers’ request the Company may sell seasonal products on a bill-and-hold basis provided that the goods are completed, packaged and ready for shipment, such goods are segregated and the risks of ownership and legal title have passed to the customer. The amount of such bill-and-hold sales at December 29, 1997 was approximately 3 percent of consolidated revenues.

Eventually, Dunlap was fired when the board of directors realized that he had done little to improve the company’s financial situation and had used improper financial engineering to drive the stock price higher.

Seller Records Revenue upon Shipment to Someone Other Than the Customer

The auditors often look at shipping records as evidence that the seller delivered the product to the customer, allowing revenue to be recorded. Management might attempt to trick its auditors (and its investors) into believing that a sale occurred by shipping products to someone other than the customer. Consider the case of Krispy Kreme Doughnuts.

Part of Krispy Kreme’s revenue comes from selling doughnut-making equipment to its franchisees. It certainly would be appropriate for the company to record sales revenue upon shipment of a machine to a franchisee—provided, of course, that the machine was actually
received
by the franchisee. In 2003, Krispy Kreme went to great lengths to fool its auditors by pretending to ship equipment to franchisees. It actually shipped the equipment out, but to company-owned trailers to which the franchisees had no access. Krispy Kreme still recorded the revenue, even though the franchisees had failed to take possession of the machines shipped.

Be Wary of Consignment Arrangements.
Another technique for prematurely recording revenue at the point of shipment involves consignment sales. With such sales, the products are shipped to an intermediary, called a
consignee
. Think of the consignee as an outside sales agent who is given the task of finding a buyer. The manufacturer (called the
consignor
) should recognize no revenue until the sales agent consummates a transaction with an end customer. If the consignor records revenue upon sending products to the consignee, but before the goods are sold to the end user, no revenue should be recognized. Sunbeam, not surprisingly, failed to account for consignment sales appropriately by recording $36 million in consignment sales before an end user had been found.

Who Is the Actual Customer—the Distributor or the End User?
In certain industries, a complication arises in recording revenue concerning who should be considered the “customer.” In the semiconductor industry, for example, a manufacturer may sell products to a distributor, who then resells them to end users. The manufacturer can choose to record revenue when the products are sold to the distributor (called
sell-in
) or when they are ultimately purchased by the end user (called
sell-through
). Both approaches are widely used and indeed permissible under GAAP. Investors should be wary, however, when a company switches from the more conservative sell-through to the more aggressive sell-in model. By doing so, the company accelerates recognition of revenue and artificially boosts profits.

Consider the change made by electronic storage company McDATA Corporation (now part of Brocade Communications Systems Inc.). McDATA buried a change in revenue recognition policy in its October 2004 10-Q, stating that revenue would now be recognized much earlier—at the point of sell-in rather than sell-through. (See the company’s statement on the next page.) What was particularly troubling was that even with the more aggressive revenue recognition method, sales growth remained flat. In the absence of this change, revenue clearly would have been declining.

Investors could have quickly spotted this problem by identifying a large increase in accounts receivable while sales remained unchanged, causing DSO to increase to 60 days from 50 days the quarter before. (See Table 3-4.) Diligent investors would have tracked down the reason for this increase and found McDATA’s change in revenue recognition policy. This example demonstrates the importance of investors going beyond evaluating whether an accounting change complied with GAAP. Investors should always ask the question, why make this change, and why now? In many cases, an accounting change—even a permissible one—is an attempt to hide an operational deterioration.